Question

1. Briefly describe the three approaches that are used to estimate the cost of common equity. Which approach is most commonly used in practice, and why? Post a follow-up question to further the discussion.

2.What is the preemptive right? How important is this to the average stockholder of a firm whose shares are traded on the NYSE? Is this more important to stockholders of publicly owned or privately held firms? Explain.

Answer 1

1. Three appraoches that are used to estimate the cost of equity are as follows :-

1. Capital Asset Pricing Model

This model is used to ascertain the expected rate of return of a risky asset. It states that expected rate of return on a risky asset is a sum of risk-free rate and risk premium.

2. Dividend Discount Model

The second approach is dividend discount model . It states that the intrinsic value of a stock is equal to to the present value of all the expected cash flows from the stock.

3. Bond yield plus Risk-Premium

This approach assumes that the common equity is costlier than the debt and estimates the cost of equity as premium over the cost of debt.

Capital Pricing Model is most popualr approach among these three approaches.

Reasons :-

• It is a simple calculation that can be stress - tested to provide various possible outcomes.
• The assumption that investors hold diversified portfolios ,eliminates unsystematic risk.
• Takes into account systematic risk, which is ignored in other approaches.

2. Preemptive right .

This is the clause that gives shareholders a right to buy additional shares in any future issue of the corporation's stock before these shares are available to the general public.

Importance for average stockholders :-

If rights offering is used to effect the stock- split ,or if it is being used to reduce the underwriting cost of an issue then this right is beneficial to average stockholder and hence important to him or her.

This right is more important to stockholders of privately held firms who are interested in keeping their control in the firm.